Asset Securitization Report - Pricing Issues For Utility ABS

Pricing Issues For Utility ABS
April 2012

Utility tariff securitizations - which allow former monopolies to recover upfront their investments in equipment, deferred power procurement or the cost of storm damage - have not always been controversial.

But two recent deals, issued just months apart by utilities in the same state, illustrate the wide discrepancy that can occur in the pricing of even the highest rated tranches.

In March, American Electric Power's (AEP) Texas Central Co. (TCC) closed an $800 million securitization backed by customer charges to recover costs related to the deregulation of Texas' electric market. Its $310 million, approximately 10-year, triple-A tranche was priced at 70 basis points over swaps. The deal was underwritten by Morgan Stanley.

Just two months earlier, in January, CenterPoint Energy, an electric and gas utility based in Houston, completed a similar securitization. Yet its $684 million, approximately 10-year, triple-A tranche was priced 20 basis points wider at 90 basis points over swaps, according to the deal's term sheet. The offering was underwritten by Goldman Sachs.

Goldman did not respond to requests for comment.

Joseph Fichera, chief executive officer of New York-based Saber Partners, a financial advisory firm for corporate and public-sector entities and an expert in utility securitization, believes that the Goldman-led underwriting group might have misjudged the amount of investor demand and priced the longest tranche on the CenterPoint deal higher by 40 basis points, at least. The pricing on the AEP transaction, while better, was still worse than other bonds of similar credit quality and size at the time.

Fichera, who is also a senior advisor to the brokerage firm The Williams Capital Group, bases his assessment on discussions with investors, comparables trading in the market at the time and research that Citigroup Global Markets published on estimates for fixed-rate pricing spreads for the week the CenterPoint deal priced.

Unlike other securitization structures, utility ABS deals benefit from the so-called "true-up" mechanism that requires the securitization structure to recalculate charges if necessary to ensure the expected recovery of amounts sufficient to timely pay all scheduled payments of principal and interest on the bonds.

Of the 36 bonds rated by Fitch Ratings, 21 have used these funds to cover shortfalls. An outlook and performance review for U.S. utility tariff ABS that Fitch published in March showed that four of the 36 bonds were required to withdraw funds via true-ups within the first several reporting periods following the deal's closing. Fitch attributed these cases to an inaccurate forecast of the initial tariff at close.

Tariffs are typically determined on forecasted customer utility service consumption, and shortfalls happen when consumption is inaccurately forecasted or if customer delinquencies or charge-offs exceed prior estimates.

There is no "cap" on the level of transition charges that may be imposed on consumers of electricity to pay on a timely basis scheduled principal and interest on the bonds, according to the regulator, the Public Utility Commission of Texas. Through the true-up mechanism, retail electric customers share in the liabilities of all other retail electric customers for the payment of transition charges.

To the extent that utilities overvalued the fixed investments when setting the customer surcharge, this could in fact lead to the consumer "overpaying."

In November 2011, Fichera testified before the Senate Energy & Public Utilities Committee that "involving independent advisors in securitization balances the various interests and ensures ratepayers don't overpay for the various transaction costs. This is not an off-the-shelf financing... it's unique in that not one penny of shareholders' dollars are at risk. The total burden goes to ratepayers." According to Fichera, in states like Florida, West Virginia and New Jersey, regulators and utilities have agreed that with ratepayers' money at risk, it's in the state's interest to ensure that they get the best deal by making sure they are represented at the negotiating table.

Matthew Butler, a spokesperson at the Public Utilities Commission of Ohio (PUCO), explained that regulators value the assets when they were approved for deferral. "It's a fixed, known amount that we'll be dealing with, so (the consumer overpaying) is not a concern," he said.

In December of last year, Ohio became the 20th state to pass legislation allowing utility debt securitization of what are called "phase-in-recovery bonds." These assets include fuel and infrastructure costs as well as environmental clean-up expenses that the PUCO has allowed a utility to defer and collect from customers at a later date.

Under the bill, only assets that the PUCO has previously ordered to be deferred can be securitized (costs for fuel, infrastructure costs and environmental clean-up expenses). From the time of a financing order application, the PUCO has 135 days to approve, modify, suspend or reject an application.

Butler, however, noted that when it came to setting the rate on the bonds, the PUCO itself will not come to market, so it does not have a say in setting the market price. "These are 'AAA'-rated bonds because the funding stream is so secure," Butler said.

Secure Assets

Because of "true-ups," utility securitizations function more like a government-guaranteed corporate security. The bonds in these structures are supported by the powerful regulatory authority over the pricing and sale of an essential commodity - electricity.

The money comes from the ratepayer, and regulators have the final authority over the utilities and ratepayers. It is the regulators that set the rates and irrevocably agree to increase the rates as necessary to pay the bonds back on time. Properly structured, even a bankruptcy of the utility sponsor would not impair the credit of the bonds.

This was proven when Pacific Gas & Electric, the country's largest utility, fled for bankruptcy protection in 2001. "The billions of dollars of securitization bonds that a subsidiary of the utility had sold just three years earlier were unaffected," Fichera said. "They were not even put on a watch list. In fact, none of these types of bond have, ever, before, during or after the credit crisis. Unfortunately, even the U.S. government can't say that."

A pricing discrepancy like the one between the two Texas deals done at the beginning of the year, he said, highlights the need for broader marketing, diligence, oversight and strong negotiation associated with these deals. "All 'AAA's are not alike," explained Fichera. "All underwriters are not alike, and marketing matters. In a negotiated pricing, one needs to demonstrate value and negotiate hard."

However, the idea that self-interest propels deal making in the capital markets is not new. Usually at the negotiating table there are those who will pay the bond and those who set the interest rate on the bond. For utility ABS, the companies are not ultimately responsible for paying the bill.

J. Paul Forrester, a corporate finance and securities lawyer at Mayer Brown, said that the two deals were very similar and he suspected that the pricing difference was attributable to different market conditions. "There has been a general tightening trend this year, although 20 basis points for triple-A utility securitizations seems like a lot," said Forrester in an e-mailed response. He noted that secondary pricing should "correct" for initial spread differences. If the deals are other- wise substantially similar, they should trade at prices that have the same or comparable yield with possible liquidity and other "adjustments."

Securitization Benefits

On the other hand, "a deregulated market means the consumer should be getting a lower all-in price for utility services given the elimination of a monopoly-type pricing environment," an investment banker said.

According to a spokesperson at AEP, recovering these "sunk costs" through typical regulatory cost-recovery mechanisms would lead to sudden, significant rate increases for consumers, commonly referred to as "rate shock." AEP services Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia.

"By securitizing these costs, the utility gets quick cost recovery, but the impact of that recovery is spread over a longer period for the consumer to reduce the rate shock," the spokesperson said. For investors, utility securitization offers access to highly rated assets with a stable cash flow, with long duration and a yield pickup over Treasuries and agencies.